Pull out all the stops

Written by Jahangir Aziz

Published: April 2, 2020 12:34:06 am

The longer such containment measures last, the larger will be the destruction to (of) demand and the bigger the collapse in output and incomes. (Illustration by C R Sasikumar)

Since last week, a sense of coherence is settling over India’s response to the COVID-19 outbreak. The national lockdown, the incomes and credit support, and the three-month debt moratorium announced by the government and the RBI are the needed first steps to contain the outbreak on the one hand, and lessen the economic impact on the other hand.

More needs to be done. But how much more? Several laundry lists of measures have already been proffered by many, and it is easy to add one more. However, these are not of much help, given the extreme uncertainty clouding how long and intensely social distancing policies will need to be pursued, the attendant economic impact and, crucially, how quickly and strongly the recovery can take place. The answer to the first depends on how much the outbreak tests the capacity of the already-stretched public health system. If the lockdown does not slow the spread of the virus to a rate that the healthcare system can handle, then the social distancing policies, in some form or another, will need to be extended. The longer such containment measures last, the larger will be the destruction to (of) demand and the bigger the collapse in output and incomes.

Then, there is the question about the pace and strength of the recovery. Much will depend on how much damage the eventual output loss inflicts on households’ and corporates’ balance sheets. For example, even if a worker starts earning once the lockdown is lifted, if one has incurred large debts in the interim, one’s consumption demand will naturally be much lower than before the crisis. The same holds for corporates, both big and small. What makes the situation worse is that there is not likely to be much help coming from global demand. We now expect global growth to decline 10.5 per cent (annualised) in 1H20 (first half 2020), considerably more than during the global financial crisis, and rebound only partially in 2H20, leaving global GDP 2.5 percentage points below its pre-crisis level at the end of this year.

Given these extreme uncertainties, it is very hard to assess the economic damage with any degree of conviction. In fact, in last week’s policy review, the Monetary Policy Committee refrained from providing any projections for future growth and inflation, breaking from its normal practice. So, if the outlook is so uncertain, how does one calibrate the policy response? One can easily under-support the economy, which could prolong the slowdown, or over-support the economy, which could end up stoking inflation (as it did in 2010-13, when the massive monetary and fiscal easing during the global financial crisis was not withdrawn quickly) or creating asset price bubbles.

The answer isn’t throwing the kitchen sink at the problem, hoping that something might work. The way out is not to even try calibrating policies under such extreme uncertainty, but to let the size of the support be determined endogenously by the extent and nature of the economic damage.

This requires falling back on first principles. We know that the economic damage could be very large. We also know that if the damage to households’ and firms’ balance sheets is substantial, then the recovery could be delayed and weakened. This calls for extensive income support through existing government Jan Dhan and Mudra accounts to households and SMEs, and temporary tax cuts or deferments to the larger corporates. It also needs substantial cuts in indirect taxes (GST) when social distancing is relaxed.

The RBI has begun to provide support via its liquidity facility (TLTRO) and regulatory forbearance that allows banks to offer a debt moratorium to their customers for the next three months. But both these measures work through banks. Given that banks have turned substantially risk-averse because of the restructuring and bad debt problems of the last few years, the RBI likely needs to start providing liquidity directly to corporates, as recently announced by the US Fed. At the same time, any debt moratorium will reduce profit and, in turn, capital, banks might be reluctant to extend it to all their customers. Consequently, the RBI also needs to change regulations to accommodate possible shortfalls in bank capital because of the debt moratorium.

Importantly, the scope and size of such policy support need to be determined by the extent of the economic damage, and not by perceived limits about what India can afford or those imposed by existing institutional arrangements and practices. It is quite possible that the size of the economic damage ends up requiring support that widens the fiscal deficit substantially. India clearly does not have the fiscal space to provide any material economic support when measured against standard benchmarks of fiscal prudence. But this is an unprecedented shock. It calls for unprecedented responses.

The market is on edge, and fears of eventual large government borrowing has spiked long-term interest rates despite large cuts in short-term rates by the RBI, which are likely to delay and weaken the recovery. Any large bond auction by the government, even if it is offset by the RBI through open market operations, is not likely to calm market nerves and bring down lending rates. What is needed is for the government to invoke the “escape” or the “natural disaster” clause in the fiscal responsibility act (FRBM) that allows the RBI to directly fund the budget deficit without having to go through market auctions.

Such a proposal is likely to raise the hackles of any fiscal conservative and there is the natural question about how rating agencies might react. As long as the government credibly commits to reversing the action as soon as the crisis is over (for example, when GDP has returned to its pre-crisis level or thereabouts), rating agencies and fiscal conservatives alike will likely treat this kindly, as it is a response to a crisis caused not by poor economic policies, but by an act of nature.

The writer is Chief Emerging Markets Economist, J P Morgan. Views expressed are personal

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